Bitcoin Building Momentum in Silicon Valley and on Capitol Hill

Still perceived by many to be the choice of currency for shady black market dealings, Bitcoin is starting to gain legitimacy as a valid form of digital currency. A disruptive innovation that has led to a number of startups and even its own Silicon Valley accelerator, Bitcoin has already succeeded in challenging the long-held notion that governments control the supply of money. And now it has a Foundation making the rounds on Capitol Hill.

In November, Bitcoin made its political debut with a couple of Senate hearings, after which U.S. policymakers decided to adopt a “wait and see” approach. The Central Bank of China adopted the same position. Bitcoin’s proponents point that the internet faced that initial "cautiously optimistic nod" from policymakers in its early days. Other governments have banned it, such as Thailand's central bank, which declared in July that it was illegal to trade the digital currency. Yet other nations have decided to acknowledge it as an asset, such as Germany did when its finance ministry recognized it as a “unit of account”, thereby including bitcoins in its capital gains tax collection pool.

What is this financial innovation about and why is Silicon Valley paying just as much attention to it as Capitol Hill?

Bitcoin is a virtual monetary system based on a peer-to-peer model of digital tokens. Rather than relying on confidence in a central authority or third party, Bitcoin depends on a transaction ledger that is cryptographically verified and jointly maintained by the currency’s users. You can watch this youtube video, but here the basics about the Bitcoin system:

Inception: In 2008, at the height of the financial crisis, a paper published under the pseudonym Satoshi Nakamoto, outlined the technical design. In 2009, Bitcoin was implemented in open-source software. Since then, the system’s participants have added several layers of agreed-upon protocol to the original design. By the end of 2012, Bitcoin became widely popular around the world, with media increasingly covering its user growth (e.g. a Wall Street Journal story told about a couple who traveled the world using only bit coins).

Money supply: Bitcoin’s algorithms ensure that money supply can increase only at a fixed rate that slows over time, so that the currency cannot be inflated, and then stops altogether at 21 million bitcoins. So far, it is estimated that 57% of all Bitcoins have already been created.

Rules of the game: Transactions are irreversible once committed to a permanent and fully public record, called the block chain. All transactions are appended this public ledger.

Privacy: Bitcoin creates an interlocking pair of encryption keys, one private and the other public. The public key can be distributed (this is equivalent to a bank account number), and the private key is what the “account holder” must keep secret. In a transaction, the paying party signs over a portion or all of the value by using his or her private key to perform an operation.

Value: A year ago, a single bitcoin was worth about $13, but its value has dramatically increased with its popularity over the past months. The Economist reports that the Bitcoin price has fluctuated wildly in recent months, hitting $230 in April 2013, falling below $70 in July, and then exceeding $600 in November.

Governance: Bitcoin relies on technical self-correcting mechanisms based on algorithms. For protocol changes, user float ideas, implement them in software, and must then be taken up by 80% of nodes before becoming permanent.

The supporters of this new currency point out several benefits of the system, such as:

It is has become trusted utility. Sellers of goods and services are increasingly accepting bitcoins as a form of payment (e.g. Richard Branson’s Virgin Galactic has embraced the currency; a Cyprus university is allowing students to pay their tuition fees with bit coins).

It relies on the self-interest of its users.

The value of bitcoins keeps rising.

In the U.S., a bitcoin ATM is already in place in Vancouver, capturing the imagination of many more potential users.

The U.S. government’s takedown of the Silk Road site, known as the digital black market, suggests that transactions in the bitcoin system are not immune from investigation.

Government-controlled currencies also have risks, such as those posed by unregulated traders before the financial crisis.

It is a global currency, and it can be exchanged for traditional currencies.

Concerns also abound, and depending on your perspective, they could include the following:

There is risk of a bitcoin bubble with its dramatic rise in value over the past year.

The seemingly anonymous public keys, created randomly by software controlled by each user, could be tracked to an individual with enough skill. Academics have published research studies showing that it is technically possible to track the movement of bitcoins in current implementations of the Bitcoin protocol. Law-enforcement agencies would regard such findings as a good thing, but it undermines the trust of advocates of a completely anonymous online currency.

Recent disclosure that the Bitcoin Internet Payment System (BIPS) has been hacked raised concerns about digital theft of this currency, making it as vulnerable as other currencies.

Regardless of which side of the debate you are on, one thing is for sure—Bitcoin is a disruptive innovation that has captured the attention of bottom-up startup communities as well as top-down government types alike.